When a business sells a product, one of the first things that need to be considered is the price they are going to sell the product for. It needs to be a price that brings in an acceptable profit.
It is important that you take the time to do the proper calculations and determine whether you are making an adequate profit.
Many business owners carefully measure gross profit (“G.P”) to determine whether they are making an adequate margin on each item of inventory that they sell. This is only half of the equation. There are a number of factors you need to consider when it comes to determining your profit margin;
- Cost of goods; the first thing you need to look at is the cost of the goods you purchased. This is the cost that you paid initially for the products. This price is the bottom line and what you need to work up from when determining your selling price.
- Other costs; when you decide on the mark up of your products, you need to consider more than just the initial cost to you. You need to look at the other costs within the business that are contributed to your products. These costs can include storage fees, employee costs (wages etc) and insurance on the products whilst they are still in your possession. Setting a sale price without considering these can mean you are underselling.
- Stock turnover rates; how quickly are you going to be turning overstock. By calculating this you are able to determine how long you will need to store (and possibly pay storage fees) and when you are likely to need to re-order.
Return on Inventory Investment
It is common to assume that purchasing larger quantities of stock at a lower price is going to be the best practice for your business. You have purchased at a lower price, so you are able to put a higher markup on it and make the most profit, right? This is not always the case. You need to consider more than just the price that you paid initially for the product. Consider factors such as:
- The amount/units being purchased;
- The time the business will need to hold stock;
- Rate of reordering;
- Timeline until profit is realised;
- Storage and freight costs involved with storage of the product;
Which of the following produces the greater return?
A business invests $100,000 and imports a container of product which it can sell with a mark-up of 100% bringing sales of $200,000 and a gross profit of $100,000. The stock takes one year to sell, so the return on the $100,000 investment is $100,000 or 100%.
Another business invests $20,000 with a local supplier which it can sell with a mark-up of only 25%. This will produce sales of $25,000 and a gross profit of $5,000. Because of the smaller quantity purchased, the stock sells in two months. The business repeats this process five more times in the year, meaning it makes $30,000 ($5,000 six times) on its investment of $20,000 – a return of 150%.
These examples are intended to show that stock turn rates are as important as gross margins. A faster-moving low margin product may produce a better return on inventory investment (“R.O.I.I.”) than a high margin product. R.O.I.I. is a measure not only of gross margin but also of how many times the stock turns in a year.
Different businesses will have different criteria driving their inventory investment and margin decisions. The importance is to be aware that every business owner should be seeking to increase their return on inventory investment.
A large client of ours applied R.O.I.I. analysis of their inventory holdings some years ago. As a consequence, they were able to emerge $4 million in cash from inventories by recognising inventory items that were not meeting their R.O.I.I. standards. In a smaller business, the amount may be much less, but even $10,000 or $20,000 extra available cash would be helpful to many small businesses.
How do you measure the return on inventory investment?
To measure your return on inventory investment, by product if you have a small number of inventory items, or by product group if you have many:
Gross Margin x Stock-turn (=Gross margin generated in the year)
Average Inventory Value
Using R.O.I.I as part of your buying and margin decisions will increase the efficiency of your stock holdings. It can help you to understand the market positions, tailor your products to the market and bring out the best selling products in a timely manner. Another benefit of inventory analysis is that slow-moving or obsolescent items are identified, perhaps allowing sale of these items before they become completely redundant.
Note: R.O.I.I. is also known by the acronyms G.M.R.O.I. and G.M.R.O.I.I = Gross Margin Return on Investment and Gross Margin Return on Inventory Investment respectively.
Buying larger quantities may not always be the best practice for your business. Take the time to do the numbers and determine what your inventory investment return is. You may be making a profit already, but can you increase that with just a few changes to your buying patterns?
Contact us today if you are looking to gain the knowledge you need to make effective and informed decisions about your business. We are here to assist you in the capacity you need to feel confident within your business.
